Check Your Understanding:
Feasible set are all possible portfolios that could be constructed from a certain group of securities available to an investor whereas an efficient set is that portfolio in the feasible set that offers the investor maximum returns at a given level of risk .
The rate of return on publicly traded bonds can be used to assess and compare default risk. The higher the default risk the higher the rate of return to compensate investors for taking extra risk. Therefore publicly traded bonds with a higher rate of return have a higher default risk.
Real rate of return is the rate of return realized on an investment after factoring in changes in prices caused by inflation. Investors are more apprehensive of the real rate of return than the nominal rate of return because it not only evaluates increases in nominal value of an investment but also evaluates whether the purchasing power has increased. .
Risk premium is the return over and above the risk-free rate of return on a security. Issuers of a security must offer a risk premium to compensate investors who are willing to bear the extra risk and make the securities attractive.
Exercise
No, the expected return on a stock with a beta=2.0 is not twice that of a stock with a beta=1.0. Market or systemic risk is given by a measure of the beta coefficient. A stock with a beta=2.0 is twice as risky as a stock with a beta=1.0. The stock with a beta=2.0 will have a risk premium twice as much as a stock with a beta =1.0. However, the expected rate of return has a component of risk-free rate of return that is the same for both stocks. Therefore, the expected rate of return will be higher but not twice as much.
The coupon rate will have the highest value while the yield to maturity will have the lowest value. A fall in the interest rate will cause the price of the bond to rise. This will not affect the coupon rate since it is based on the par value which is fixed. Since the bond is selling at a premium, there will be capital losses for investors who paid face value and intend to hold the bond until it matures hence lowering the yield to maturity.
It is important to associate an expected return with its risk measure in order to factor in the possibility that the cash flow may be different from the expected, or may not materialize completely based on the inherent risk of the asset.
The asset with a higher rate of return and a higher standard deviation will always lie on the efficient frontier. This is because along the efficient frontier curve, the higher the risk, the higher the returns. None of the assets can be efficient when held alone. The portfolio must have a mix of both assets to maximize the expected returns while minimizing risk.
References
Fabozzi, F. J. (2011). The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies (illustrated ed.). New York: John Wiley and Sons.
Smart, S. B., Megginson, W. L., & Gitman, L. J. (2008). Corporate Finance (2,ed ed.). Thompson South-Western: Cengage Learning.
